Dynamics of Money Demand and Supply in the US Economy

Abstract

Money demand and supply are the more concerned topics of discussion among policymakers in all modern economies. This paper utilizes the three-stage least squares method to investigate the dynamics between money demand and money supply within the context of the U.S. economy. Our analysis reveals significant relationships between these monetary variables and various economic indicators. Specifically, we find that the demand for money is inversely related to the interest rate while being positively influenced by real GDP and the nominal effective exchange rate. In contrast, the supply of money exhibits a positive correlation with the interest rate and an inverse relationship with both the output gap and the inflation gap. Our findings indicate that as interest rates increase, the demand for money decreases, highlighting the traditional view that higher interest rates discourage holding money due to the opportunity cost associated with forgoing higher returns on alternative investments. Conversely, an increase in real GDP leads to higher money demand, reflecting the greater need for transactional balances in a growing economy. Similarly, a rise in the nominal effective exchange rate boosts money demand, possibly due to enhanced purchasing power and increased foreign trade activities. On the supply side, our results suggest that the Federal Reserve adjusts the money supply in response to fluctuations in the interest rate, output gap, and inflation gap. A higher interest rate prompts an increase in the money supply, which can be interpreted as a monetary policy response to stabilize the economy. Meanwhile, an expanding output gap, which indicates economic growth above potential, or an increasing inflation gap, signaling rising price levels above the target, would lead the Federal Reserve to reduce the money supply to cool down the economy and control inflationary pressures. These insights underscore the intricate balance the Federal Reserve must maintain in its monetary policy decisions. The inverse relationship between the output gap and inflation gap with money supply suggests a proactive approach by the Federal Reserve to mitigate overheating in the economy and ensure price stability. This study contributes to the broader understanding of monetary policy dynamics, offering valuable implications for policymakers aiming to achieve economic stability and growth.